FBIAS™ for the week ending 10/10/2014

In the “decades” timeframe, we have been in a Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E, or “CAPE”) peaked at about 44. The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge. See graph below for the 100-year view of this repeating process.

If history is a guide, we may not yet be done with this Secular Bear Market. The Shiller P/E is at 25.0, down from the prior week’s 26.1, and approximately at the level reached at the pre-crash high in October, 2007. Even though P/E’s are substantially lower than their crazy peak in 2000, they are nonetheless at the high end of the normal historical range and leave little if any room for expansion. This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that. (note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see robertshiller.com for details).

In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see graph below).

This further means that above-average returns will be much more likely to come from the active management of portfolios than from passive buy-and-hold. Although a mania could come along and cause P/E’s to shoot upward from current levels (such as happened in the late 1920’s and the late 1990’s), in the absence of such a mania, buy-and-hold investors will likely have a long wait until the arrival of returns typical of a Secular Bull Market.

In the big picture:

The “big picture” is the months-to-years timeframe – the timeframe in which Cyclical Bulls and Bears operate. The US Bull-Bear Indicator (see graph below) is at 55.1, down from the prior week’s 58.8, and continues in cyclical Bull territory. The current Cyclical Bull has taken the US and some of Europe to new all-time highs, but many of the world’s major indices have yet to top 2007’s levels. The most widely followed international indexes, the Morgan Stanley EAFE Developed International index and the Morgan Stanley Emerging Markets Index, are both still below their 2007 peaks.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) ended the week at 7, down sharply by 9 from the prior week’s 16, and in Negative status. Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of October for the prospects for the fourth quarter of 2014.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2 above), the Secular Bear may still be in force as the long-term valuation of the market is simply too high to sustain a new rip-roaring Secular Bull. In the Cyclical (months to years) timeframe (Fig. 3 above), all major equity markets are in Cyclical Bull territory. The Bond market returned to Cyclical Bull territory as of February 28th. In the Intermediate (weeks to months) timeframe (Fig. 4 above), US equity markets moved to Negative status on October 1st. The quarter-by-quarter indicator gave a positive signal for the 4th quarter: US equities were in an uptrend, while International equities were in a downtrend at the start of Q4, and either one being in an uptrend is sufficient to signal a higher likelihood of an up quarter than a down quarter.

In the markets:

The week ending October 10th was the worst week of the year for the US and many other markets. The Dow lost -2.7% (and is now negative for the year), the S&P 500 dropped -3.1%, but the other US indices were substantially worse with the Nasdaq and SmallCap Indices shedding -4.5% and -4.7% respectively. To call the week’s action whippy would be an understatement: Wednesday saw the year’s best one-day gain for the Dow, but then Thursday endured the year’s worst one-day Dow loss.

Canada’s TSX lost -3.8% for the week, and joined the Russell 2000 SmallCap index in having lost ground for 6 weeks in a row. International indices outside of Europe were less drastic in their losses, perhaps because they have already shed quite a bit more than the US. Brazil, for example, gained +3.2% for the week, but is already down -22.2% from its highs of the year. Developed International has shed -12.8% from its highs, and Emerging International -11.6%. Among US indices, only the Russell 2000 is down double-digits from its early-year highs, at -12.9%. Canada’s TSX is not quite to a double-digit decline, either, at -9.1% from this year’s high. After the dust settled for the week, calmer voices pointed out that the bellwether S&P 500 is still only down -5% from its all-time highs of just a few weeks ago.

In the US, earnings season is in full swing with no major surprises yet save for some negative outlooks from semiconductor companies, with one – Microchip Technology – forecasting a general semiconductor industry slump. The giant rally on Wednesday was sparked by the Fed minutes revealing that sluggish (or no) global growth has entered into the calculus of the Fed – a new consideration, not heretofore articulated in Fed statements. Since global growth is at best sluggish, investors took that to mean that low/no global growth will further postpone Fed tightening, and bought furiously…for one whole day. The 10-year note soared as rates dropped to 2.3%, their lowest level in more than a year. Unlike the stock rally, the 10-year rally was not reversed and closed the week at their highs. In other US economic news, initial jobless claims dropped to 287,000 and the 4-week average is now at the lowest level since 2006. Mortgage rates hit a 4-week low, and refinance applications rose 5% from the prior week.

Canada’s jobless rate fell to 6.8% in September, from 7.0% in August. 74,000 new jobs were added, almost all full-time positions. The Bank of Canada’s governor Stephen Poloz, however, focused on the lack of a rise in the number of hours worked, which has remained stagnant, saying “An economy that’s actually growing in a self-sustaining way is going to generate quite a bit more draw on the labor market than that. When you start talking about slack, it’s going to take a substantial, cumulative series of good reports to begin to put a dent in that.” Canada has evidently had enough with the US’ waffling and endless delays of the XL pipeline project, so the government has recently unveiled the “Energy East” project, which will transport oil all the way from Alberta and Saskatchewan to St. John, New Brunswick, for subsequent export to Europe and points east. If they can’t take it to the Gulf of Mexico through the US, Canadians are determined that their oil will still find its way to the global market.

Europe continues to worsen as the probabilities of yet another recession continue to rise. September Purchasing Managers Index (“PMI”) data on Eurozone retail sales showed the sharpest fall in 17 months at 44.8, with Germany at 47.1 (a 53-month low) and France at 41.8 (a 18-month low). Values below 50 indicate contraction. Phil Smith, economist at Markit (publisher of PMI values), commented “Consumer spending in the euro area looks to be on the downturn, with the latest retail PMI figures showing sales falling for the third month running.” For the first time since January 2009, Germany reported worse figures than its Eurozone compatriots. Factory orders fell -5.7% in the month, industrial production was down -4%, and exports declined -5.8%. France teeters on the brink of recession, or perhaps is already back in recession, yet has not done anything substantive to get its fiscal house in order. Public spending takes up 57% of France’s GDP – by far the highest in the Eurozone – and France hasn’t had a balanced budget in 40 years.

So, is there anything going up these days? One area of continued rapid appreciation is…American farmland, especially as expressed in multiples of rental charges. Here’s an amazing chart showing the unabated rise in farmland values in America’s heartland:

The ranking relationship (shown in graph below) between the defensive SHUT sectors (“S”=Staples [a.k.a. consumer non-cyclical], “H”=Healthcare, “U”=Utilities and “T”=Telecom) and the offensive DIME sectors (“D”=Discretionary [a.k.a. Consumer Cyclical], “I”=Industrial, “M”=Materials, “E”=Energy), is one way to gauge institutional investor sentiment in the market.

The average ranking of Defensive SHUT sectors rose to 5.8 from the prior week’s 8, while the average ranking of Offensive DIME sectors fell to 17.3 from the prior week’s 16.3. Institutional investors remain cautious, and the Defensive SHUT group ranks higher than the Offensive DIME group ranking by the widest margin in more than a year.

Note: these are “ranks”, not “scores”, so smaller numbers are higher ranks and larger numbers are lower ranks.

Summary:

The US has led the worldwide recovery, and continues to be among the strongest of global markets. However, the over-arching Secular Bear Market may remain in place even as new highs are reached in the US.

Because we may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence. Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.

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